30 Jul


Merriam-Webster defines "euphoria" as "a feeling of great happiness and excitement." This may be an appropriate description of investors' emotions in the next phase of the bull market. As the depths of the financial crisis become closer to "long-ago history" with each passing day, investors, as a whole, continue to gain comfort that the world is not going to collapse. We navigated the recovery, survived complacency and now look ahead to the next part of the cycle feeling to some like it will be the best. However, history has proven it can be the most dangerous and you do not when it's over until it is too late. 

The 2014 second quarter marked the sixth straight period of positive returns for the stock market as a whole. This is an interesting factoid and not without precedent. In fact, we are only halfway toward setting a new modern history record for consecutive quarters of positive returns (as measured by the S&P 500 Index). The previous record stands at 11 quarters and dates back to the early 1960's. While reviewing past performance in a historical perspective can be of interest, as fundamental-based investors, we are far less concerned with prior price movements and focused on future possibilities. Returns moving forward should be independent from those that came before it.



The current macro outlook for investors has not changed much despite the increased tension in the Middle East and the plot-thickening situation with Russian and the Ukraine. Both the stock and bond markets remain relatively unfazed which has investors of all types experiencing a positive view of the marketplace.

To be balanced, we need to broaden our look beyond these media-rich affairs as there are plenty of other issues outstanding - some global, some national - that are not dissipating: the state of global debt and the tenuous situations of many government budgets. Unfunded state and private pension plans, a shrinking middle-class and a crumbling infrastructure all present future risks (and opportunities). These issues are widely known and, we presume, priced into current security prices. So when (not if) we experience a significant sell off in asset prices, it will likely be initiated by an event that is unknown to virtually everyone, as it is rational human behavior to fear the known, but not the unknown.

There is a widely quoted index that measures volatility in stocks referred to as the VIX. This index takes its inputs from the options market and is interpreted as a fear gage. The more fear, the more investors are willing to pay for options (insurance). Needless to say, this index was at extraordinary levels during the 2008 and 2009 crisis. Today, it is at record lows.

To be clear, we are not currently in a euphoric state, just getting closer. It may not be right around the corner but there will be signs. One such sign we expect to observe is when we experience a "melt up" in equity valuations and prices. One could argue that we had that last year with 30% rises in U.S. stock prices, but traditional measures of stock values remain reasonable especially when compared to bond and commodity prices.

In large part, global central bankers are to thank for the rise in stock, bond and real estate markets. Most have followed the same play book in recent years by flooding the world with currency. By forcing interest rates down, riskier assets (equities) look more attractive.

A common thought is that interest rates should rise when inflation appears and that should lead to poor returns for owners of marketable securities. We agree with this concern and feel that we are far away from this scenario occurring. The world's markets are interconnected and growing closer every day. This leads us to conclude that interest rates will remain low for an extended period of time and when central banks begin the process of influencing interest rates higher, they will act very slowly to prevent any downturn resulting from the process. This leads us to favor equity ownership (versus fixed income) for the foreseeable future.

Thank you for your time and we look forward to our next conversation.


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